The Third Pig

Target (TGT) reported earnings today and beat estimates by 5 cents per share. The second quarter (fiscal year 2009) earnings report show the company had made 82 cents per share which amounts to $634 million in profit for the quarter. This might have been better news had estimates not been lowered ahead of Target’s announcement. Given the turmoil in the economy, it is no wonder the company posted its fourth straight quarterly profit decline.

But long term investors in the company should take solace. Target is one of the best-managed and most profitable retailers in the world. It is competitive with Wal-Mart (WMT) on a price basis on most of the items both stores carry, but the typical Target customer earns over $20,000 more per year in income than does the Wal-Mart customer. Right now, in this tough economic environment, customers prefer Wal-Mart to Target based on the perception the latter store is more expensive. There is some buzz on Wall Street the company needs to let consumers know the retailer are just as “cheap” as the competition. However, based on findings regarding human behavior as it relates to consumerism, this would be one of the worst things Target could do. There is a peculiar human trait that wants to believe the more one spends, the more valuable the purchased item is, even if one only perceives he or she has spent more. People value items based on price instead of pricing items based on value. Thus Target has a competitive advantage over Wal-Mart in the minds of most consumers during better economic times.

To illustrate allow me to point to two studies which examine the role price plays in a person’s ultimate purchase satisfaction.  The first study was conducted by researchers at Stanford Business School and Cal Tech. In a blind taste test drinkers were given several glasses of wine priced from $5 to $90 per bottle. The results showed the drinkers preferred the most expensive wine. What the study participants were not told was the wine was exactly the same in each and every bottle.

The second study conducted by Dan Ariely, author of Predictably Irrational, measured people’s reaction to the prices of a pill they were given to mitigate their pain. The pain as it were was delivered via electric shocks administered by the conductors of the study. The result: although the pill was the same for all participants, 85% of the participants who were told their pill cost $2.50 felt less pain while only 61% of those who were told their pill was only 10 cents felt less pain. In the minds of the participant, the more expensive the pill, the more effective it was.

The “predictably irrational” behavior of people at it relates to their wallets has a couple of implications for Target. The company can use this information in two ways. The company could and should raise its prices above similar items found at Wal-Mart. In good economic times, all things being equal, consumers will prefer the perceived higher price alternative thus they will choose Target over Wal-Mart. Although in bad economic times, they may choose Wal-Mart. This actually has some merit as during the 5 year period ending April 2006, a period of economic expansion, Target’s stock clearly performed better than Wal-Mart’s (first chart). However, since then during an economic downturn, Wal-Mart has outperformed.

Since this is a counterintuitive approach it is not likely Target will go this route. Thus, if Target is going to continue be price competitive with Wal-Mart, it should market or continue to market itself as Targét (Tarjay) instead of just plain old Target. That way, it will continue to keep its higher earning customers and not lose them because they are not charging enough.

All that said Target remains a great buy at this level, $49.72 as of this writing. Simply based on its earnings potential, it is worth at least $60 per share. Additionally, since selling half its credit card receivables to JPMorganChase for nearly $4 billion in March of this year, it is likely to redirect that money to share repurchases that will serve to further increase the value of the stock. For the quarter, Target has spent $4.9 billion of the $10 billion it plans to spend on share repurchases. And it has a real estate portfolio (it owns the land its stores are on) with a book value of $25 billion and worth at least $30 billion. That represents 75% of its market cap.

Buying in at these levels (not a recommendation; see disclosure) seems like a no brainer.

Disclosure: I and the clients of Brick Financial owned shares of Target (TGT) at the time of this writing however did not own shares of Wal-Mart (WMT).